Posts Tagged With: Investors

Martin Brassell, CEO of Inngot, considers how founders can realise value from their hard work in a pre-start context

There are many areas in which expectations differ between investors and entrepreneurs seeking investment. One of the areas that often proves hardest to resolve is the question of valuation, especially if a business is yet to generate first revenues.

‘Sweat equity’ is the delightful term coined to describe the value to be placed on the efforts expended to bring an opportunity to the point of realisation. At the point when a business is first presented to independent investors, rather than a more receptive first audience of ‘friends and family’, entrepreneurs will often strive to place a financial value on their labours. From their viewpoint, this is a perfectly reasonable thing to do: after all, no-one doubts that bringing an innovative idea to market involves a lot of perspiration as well as inspiration.

Any investor worth having knows that the road to success is generally a steep one, and likely to require a good deal more sweat to be expended. He or she also understands that it is counter-productive to leave a founder so short of equity that they lack the commitment and energy to make the climb. However, the risk climate dictates that this is a buyer’s market at present, in which any valuation is bound to be subjected to close scrutiny, and needs to be as objective and well-evidenced as possible.

How does sweat get expressed? Generally as a factor or multiple of the salary that the entrepreneur(s) would be earning if they were in some notionally equivalent employment (or still in a previous job). The more senior time and energy put into an opportunity, the more it should be worth, and this method quantifies it – right?

Sorry – wrong, on a number of counts. To begin with, this approach assumes that hard cash and theoretical cash are equivalent in value. In reality, there is always an exchange rate in action. Sometimes this works in the founders’ interests, if they manage to get an opportunity to a point where it clearly has vastly more value than the time they have expended on it would indicate. But on other occasions, the investor is being expected to put in new cash to realise an opportunity that the theoretical cash has failed to deliver on its own. They will understandably take the view that their ‘real’ money is more risky and should attract a premium.

Even if a pound-for-pound calculation were appropriate, an investor has no way of auditing the amount of time that has actually been invested, or knowing whether the salary sacrifice implied is real or not. Certainly, people do sometimes jump out of highly paid jobs to create new ventures: but on some level, the saying that “necessity is the mother of invention” is generally applicable to entrepreneurial motivation as well as to the innovations themselves. And there is a more fundamental problem, which is the underlying premise that cost is equivalent to value.

Plainly, it’s not. The fact that it costs one company twice as much as another to produce a given widget does not translate into 2x value that the market can see. To take a less obvious example, many endeavours involve going down a number of what prove to be blind alleys. This creates ‘negative know-how’ – understanding what doesn’t work. It has some value, but clearly not as much as actually discovering the ‘secret sauce’.

To present a more compelling case requires a focus on what a pre-startup has actually been able to deliver to date. This involves consideration of assets, and since few start-ups are well enough funded to invest much in tangible ones, it inevitably comes down to the value that an investor can see in the opportunity and the company’s capacity to realise it based on a) the quality of the team (if there is one) and b) the quality of the approach embodied in its intangible assets.

An investor needs to see how the sweat invested by founders has translated into assets that create income, ‘freedom to operate’ and/or ‘barriers to entry’. Not all these assets are equal, and the type most highly prized will generally firm orders, often in short supply. However, any such orders are likely to have been secured based on capabilities that are underpinned by intellectual property and similar rights.

The more comprehensive an inventory of assets a business can produce, the better its prospects of attracting favourable attention, and the more likely it is that an investor will see that there is something of value at the heart of it. The present day value of those assets can then be extrapolated from the scale of the opportunity they enable a company to realise, and the length of time it will take for an investor’s new money to enable that opportunity to start to be realised. This comes down to having a credible and well drafted business plan, in which the risks and their mitigants are given proper consideration.

So the secret of expressing the value of sweat is simple: don’t focus on how much time you’ve spent – instead, show what you have been able to do with it.

Traditionally, “innovation” has been viewed as being synonymous with scientific discovery and the development of new physical products. Accordingly, it has been measured using established yardsticks such as research and development expenditure and patent production.

However, in the UK, the service sector now counts for over 75% of added value, and technical development is often realised in software, which is seldom patentable. This changing economic emphasis has led to a growing acceptance that traditional measurements, and traditional approaches to intellectual property (IP), no longer reflect how innovative any given company or sector actually is. In July 2008, DIUS asked NESTA to launch consultation on a new Innovation Index, on the basis that innovation “now encompasses not only the development of new components and products but new services, technical standards, business models and processes.”

As the legal means to protect “literary works” of all kinds, including software, copyright is the type of IP that is arguably most vital in understanding and developing the UK’s knowledge economy. The drive to exploit this automatic right more effectively is being led by Inngot, a private venture, which is launching a new service to register and publish copyright material. It enables innovative businesses to use their IP to attract customers, find collaborators, and secure finance and investment.

Inngot’s views coincide with the conclusions of the far-reaching Gowers report into IP policy, commissioned by HM Treasury and published in December 2006. Rather than extend monopolistic patent rights into software and business models, this recommended (among other measures) that government agencies should collaborate with others to improve the coverage of copyright.

The versatility of copyright

The principal reference point for current UK copyright law is the Copyright, Designs and Patents Act 1988 (“the Act”). According to the Act, copyright automatically arises when an original work is recorded, an approach which is mirrored in most other markets, and lasts for up to 70 years. Where copyright material is created in the normal course of business activities, it generally belongs to the employer by default (and there are no moral or other rights provided in law for the creator of any computer-generated material if they work for someone else).

Under the provisions of the Act, software has the same protection as other written work. Strictly speaking, this level of protection covers the expression of an idea, rather than the idea itself. However, the two concepts are not mutually exclusive; in the case of software, the expression of an idea in code is what gives it an effect. Moreover, it is not only lines of code that can be protected – tables and compilations are specifically included in the scope of the Act, and even diagrams can also count as original artistic works.

As a type of property right, copyright can be fully or partially assigned (i.e. sold) to another party. It can even be assigned before it has been recorded, creating an entitlement to work which has not yet been created. While this practice is most familiar in the context of book advances, it could prove equally applicable to software.

Copyright infringement

A copyright owner whose copyright has been infringed has a right to damages, and can take out an injunction to prevent further breaches. Under the Act, a copyright infringement by a company that occurs with the consent or connivance of a director or manager of a business can also make them personally liable for damages.

However, if the infringing party did not know, and had no reason to believe, that copyright existed in a work then there is no entitlement to damages. This provides a vivid example of the importance of publicly asserting copyright in any original work, so that it falls clearly within the scope of the law (and another benefit of registering and enquiring with the new Inngot register).

In addition to a “fair use” exemption for purposes such as legitimate research, copyright is not deemed to have been infringed unless a substantial part of a work has been copied. However a part may be “substantial” because it represents the most original and distinctive aspect of a work – the calculation is not simply one of volume, and case law has established that even a very small part of an original work can prove to be substantial in this context.

One popular misconception is that copying needs to be literal (i.e. word for word) in order for there to be an infringement. This is not necessarily the case: copying can also be demonstrated where it is not literal, provided that the material in question is expressed in the work and is not merely an idea (for instance, the plot of a literary work can be protected by copyright as well as the words on the page which explain it).

This is an interesting precedent which demonstrates that software, as a “literary work”, could also enjoy copyright protection if the substance of its code is copied, even though the exact form of words may differ.

Inngot in the knowledge economy

Whether they are seeking to assert their rights to copyright material, or trying to ensure that they are not in breach of existing copyright, knowledge economy businesses have been disadvantaged by the lack of a trusted central repository for “unpublished” material (i.e. copyright material that is not on general release).

Inngot addresses this by providing a common language to describe innovative businesses and their IP, and by publishing it in a secure environment protected by copyright. In doing so, it provides the significant benefit that a business can assert its ownership of specific IP without the downside risks of detailed disclosure – which is a statutory requirement prior to receiving patent protection.

Inngot does not duplicate the statutory registration regimes for patents and trade marks. By contrast, it harnesses the flexibility and dynamism of copyright to enable software and service businesses to express what makes them special.

Compare a company’s market capitalisation with its tangible assets and you’ll find a gap of up to 75%, which IP experts assure us rests in intangible assets.

However, in a survey, the Intellectual Property Office who issue patents in the UK found that 86% of UK businesses were either ignorant or misinformed about how to protect and make best use of these “valuables”. The survey was conducted in 2006, but there is little evidence that things have improved since.

If UK plc is to pull its way out of recession based on innovation (as the government seems to believe), companies need to get better at understanding their intellectual assets, and leveraging their knowledge and technology to get finance and business through the door.

The IPO says the problem is particularly acute among smaller businesses: “SMEs and the mass of micro-enterprises (businesses with 0-9 employees) which form the cradle of IP and future large companies are in the main effectively unaware of the IP system”.

This assessment does seem unduly pessimistic, and reflects the fact that current debate too often focuses on formal registered rights, especially patents, as being synonymous with IP.

There is no doubt that for some businesses patents are helpful or even essential, but they do not sit well with knowledge economy companies, especially those whose innovations lie in software.

The patenting process often requires specialist expertise, making it costly (officially estimated at up to €50,000 for an EU patent) and time-consuming: the fastest I have personally encountered took some 17 months from filing to publication date, and 2-3 years is more normal.

In a world moving towards increasingly open models of innovation, this combination of high cost, lengthy time to market and defensive intention makes patents an appropriate option only in a limited number of situations.

In fairness to the IPO, strong rights should be backed by rigorous processes, and these will take time – once an application has been submitted, the IPO checks it against existing published patents, and if the application passes this process then a patent is granted, normally in the two to three year time period.

But many small firms now question how advantageous these rights really are in practice, given that their large competitors often have sufficient financial muscle to render patents very difficult to enforce.

Surely the answer is broader and simpler – it’s to make more of copyright. While it’s recognised that copyright is fundamental to creative works, many of which are now digital, its importance as the underlying right to protect all types of software is not well understood, other than in the context of piracy.

Copyright is automatic and it’s long lasting; it’s remarkably consistent internationally; it can be used to sell, assign, transfer or licence intangible assets; it can even be assigned in works that are not yet complete.

In working with young businesses over many years I learnt to be wary of any proposition that seemed to require legislative change. The good news for business in the digital age is that we already have the legal framework we need – we just have to capitalise on it better.

Martin Brassell is CEO of inngot Limited- It provides a safe and secure place for IT companies to register their intangible assets enabling companies to ‘showcase’ their IP to find customers, partners and investors.
He is also a South East England Development Agency (SEEDA) Hub Director, working to assist high potential new ventures.

Ultimately, everyone knows there is only one true arbiter of how much a given set of assets is really worth: how much someone else is prepared to pay for them. This maxim is even more applicable to intangible assets, which don’t (yet) have the same ready market as the tangible commodities companies own.

However, that doesn’t mean it isn’t possible, and necessary, to understand the quantum of value now resting in businesses’ Intellectual Property (IP) and other intangibles – even if these assets (or companies) in question aren’t currently for sale.

To get a sense of the contribution they make, we can look at how much companies spend on intangibles; how these assets appear to influence share values; and what happens when firms sell stakes based on an intangibles-backed offering.

Helpfully, the 2011 UK IP review by Professor Ian Hargreaves provides some (fairly) recent data on investment in intangibles. The report quotes Government statistics from 2008, showing that UK businesses now spend about one-third more on intangible assets than they do on tangible ones – £137bn vs. £104bn. A key contributor within this asset class is IP, estimated to account for around £65bn of this investment.

What about share prices? One of the organisations looking regularly at intangible values is Ocean Tomo in the USA. Its analysis suggests that the “80/20” rule now provides a good shorthand when thinking about the level of value in intangibles (read more here).

Back in 1975, the implied intangible asset value of the S&P500 (derived by looking at book value as a proportion of market value) was 17%: in 2010 it came in at 80% when measured on the same basis. The company attributes this “total economic inversion” to the growth of the knowledge economy, and points out that these implied values are holding up, even during a period when total R&D spend is falling (though it is still increasing slightly if viewed as a % of revenues).

Similar exercises have been done in Europe. The introductory section of the 2006 Gowers Review draws the same conclusion from an assessment of top companies quoted on the London Stock Exchange. The European Commission said in 2010 that “intangible value has accounted for approximately three-quarters of corporate value as far back as 1995.”

None of their findings should surprise us. Rewind to the 1970s, and Western economies were still largely dependent on generating value from manufacturing capacity – multiplying the power of human effort. Now it’s much more about multiplying brainpower, not brawn.

It is also clear that the characteristics that make companies attractive purchases have changed. With so much production capacity offshore or subcontracted, it’s the brands, customer relationships, service formats and software code that buyers want. Recent flotations of technology and web-based companies have generated plenty of initial interest despite very challenging market conditions; and while the initial gloss has faded from some of these offerings, the fact that they got away at all is undoubtedly due to their shiny intangibles, not their shiny servers.

It seems the pendulum has swung decisively towards valuing assets that are unique, rather than types of property that are common across many businesses. Determining an appropriate value for them poses new challenges for investors, lenders, acquirers and licensees.